Generally Accepted Accounting Principles (GAAP): A Guide
Updated February 3, 2023
Accounting professionals have an obligation to adhere to official industry standards when conducting financial reporting. By doing so, they can communicate important financial information to the public, investors and other company stakeholders. If you're seeking a role in accounting, finance, business or a related field, you may benefit from learning about key industry regulations and foundational concepts of accounting.
In this article, we define the phrase "generally accepted accounting principles" (GAAP), discuss some fundamental accounting ideas and answer a few frequently asked questions about the topic.
GAAP is a set of rules that guide accountants on how to record an organization's finances properly.
By adhering to GAAP, accountants can track an organization's fiscal health and allow auditors, lenders and other external parties to understand the organization's financial situation.
Accounting professionals also use various principles of accounting to document financial data effectively.
What are generally accepted accounting principles?
Generally accepted accounting principles are a set of official, common standards of practice among accounting professionals. Accountants are responsible for adhering to GAAP when preparing financial statements and records for public organizations. The Financial Accounting Standards Board (FASB) issued these regulations to ensure financial reporting is accurate, consistent and transparent across establishments.
The 10 key components of GAAP
Here are the 10 primary tenets of GAAP:
Principle of regularity: The accountant complies with GAAP rules and regulations.
Principle of consistency: The accountant applies the same standards throughout the reporting process to ensure comparability between periods. If changes or updates are necessary, the accountant explains these in detail.
Principle of sincerity: The accountant provides an accurate, unbiased illustration of a company's financial circumstances.
Principle of permanence of methods: The accountant conducts financial reporting procedures in a consistent manner.
Principle of non-compensation: The accountant reports all aspects of an organization's status, whether positive or negative, without expectation of debt compensation.
Principle of prudence: The accountant reports data based on facts rather than on speculation.
Principle of continuity: When valuating assets, the accountant assumes the organization can continue to operate in the future.
Principle of periodicity: The accountant reports financial data, such as revenue, within a standard accounting period, such as a fiscal quarter or year.
Principle of materiality or full disclosure: The accountant divulges all financial and accounting information related to the organization.
Principle of good faith: The accountant practices truthfulness in all financial reporting and accounting practices.
Read more: 10 GAAP Guidelines
12 basic principles of accounting
In addition to complying with the official requirements of GAAP, accounting professionals also act in accordance with various basic accounting concepts. Accountants use the following 12 principles as guidelines for recording and organizing financial data properly:
1. Accrual principle
The accrual principle encourages accountants to record a transaction during the period in which it takes place, rather than when it affects the cash flow of the organization. For example, if a furniture store sells a couch to a customer on credit, it may take months or longer for the customer to pay for the couch in full.
To adhere to the accrual principle, the store's accountant records the accrued revenue from the sale when the sale occurs. This is instead of waiting to receive the full payment before recording the transaction.
2. Conservatism principle
According to the conservatism principle, accountants recognize all potential liabilities and expenses. At the same time, they only record assets and revenues when there's a certainty of these occurring. Applying this principle can organize financial records in a conservative manner, showing lower reported profits due to the delays in asset and revenue recognition.
Related: What Are Accounting Principles?
3. Consistency principle
Accountants are responsible for using the same methods and principles to complete various tasks. Applying the consistency principle ensures that those reviewing the organization's financial documents can understand important data. Communication is essential for ensuring consistency across an accounting department.
4. Cost principle
The cost principle highlights the importance of recording equity investments, assets and liabilities based on their value at the time of the original transaction. The initial purchase price can be verifiable proof of value. This is in contrast to adjusting the record based on fair market value or inflation.
5. Economic entity principle
Because of the economic entity principle, accountants keep an organization's finances separate from those of business stakeholders or related businesses. This helps prevent inter-organizational mingling of liabilities and assets. Distinguishing business transactions from personal ones can make it easier for organizations to comply with audits.
6. Full disclosure principle
The full disclosure accounting principle ensures that accountants include all of the necessary information in an organization's financial documents. It also encourages accountants to provide details about how the business operates and maintains its financial records. This kind of data can help a reviewer decide whether to invest or lend to the company.
7. Going concern principle
The going concern principle is the assumption that a business has enough resources to continue to operate for the foreseeable future, barring any unexpected events. There's also an assumption that the business entity can avoid liquidating its assets and halting operations in the near future.
When following this accounting principle, an accountant can defer recognizing certain expenses, such as depreciation, until later because the business can recognize and manage those expenses at some time in the future.
8. Matching principle
Adhering to the matching principle, accountants record all expenses with related revenue. They match revenues and expenses on the income statement for a period of time, such as a month, quarter or year. This way, they can connect the costs of an asset to its benefits.
Read more: Matching Principle: Definition and Examples
9. Monetary unit principle
When applying the monetary unit principle, a business records transactions in currency unit terms. These terms are typically easy to understand and quantify. Using this principle allows accountants to outline transactions in a dependable and stable way. It also prevents an organization from estimating the values of its liabilities and assets excessively.
10. Reliability principle
According to the reliability principle, it's a requirement that accountants present accurate and relevant information in an organization's accounting records. When they record transactions, it means they can prove these transactions existed with actual evidence.
Some examples of objective evidence to record include bank statements, purchase receipts, appraisal reports, canceled checks and promissory notes. Vendors, customers and other external entities supply these documents, providing credibility to them.
11. Revenue recognition principle
Based on the revenue recognition principle, accountants record revenue when the organization earns it rather than when the organization receives it.
For example, if a company provides plowing services after a snowstorm, it may charge $200 for a commercial parking lot service. To adhere to the revenue recognition principle, the company accountant records $200 in revenue upon completion of the plowing job rather than when the customer pays the invoice.
12. Time period principle
The time period principle requires a business to report all its financial information within a set period of time. The business can divide all of its activities into defined time periods. Examples of the most common reporting and accounting periods include weekly, monthly, semi-annually and annually.
The purpose of this principle is to ensure that a company can produce consistent, reliable and comparable data. This is essential when an organization is going public, seeking investors or obtaining loans for business purposes.
Frequently asked questions about GAAP
Here are some frequently asked questions about the topic of GAAP:
Why is GAAP important?
GAAP acts as a common language of accounting. It enforces consistency and transparency in reporting practices across organizations. When accounting professionals all follow the same rules, they can read and understand documents from other organizations with ease. This is especially important when auditors, investors, creditors or lenders seek to review and assess an entity's financial history.
GAAP also enables accounting professionals to maintain consistency within a single organization. Standardizing and systematizing a firm's financial records can ensure those records are easy to access, monitor and understand. By using GAAP, accountants can track the organization's fiscal stability, prevent fraud and protect the firm's interests in the event of an audit or lawsuit.
What's the difference between GAAP and IFRS?
The International Financial Reporting Standards (IFRS) is a set of regulations for financial reporting. The IFRS was established by the International Accounting Standards Board. In contrast, the GAAP was established by the FASB. In addition, while the IFRS guides accountants in jurisdictions throughout the world, the GAAP primarily influences accountants in the United States.
Who uses GAAP?
While adherence to GAAP is only mandatory for publicly traded companies, it's still common among private companies. People working in a firm's accounting or business department may use GAAP. This could include accountants, bookkeepers and chief financial officers.
This article is for informational purposes only and does not constitute financial advice. Consult with a licensed financial professional for any issues you may be experiencing. Please note that none of the companies mentioned in this article are affiliated with Indeed.
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